Portfolio Positioning: Revisiting The Nemesis Theme

For some background, earlier this year BlackRock published their outlook for 2012 which consisted of ranking various themes based on probability of outcomes. The "Divergent" theme carried the highest probability and was based on:

U.S. and Japan economies muddling through

Europe experiences a modest recession

China loosens credit and reinvigorates growth (likely in 2H'12)

The adverse "Nemesis" theme was based on Europe's credit situation getting much worse and spreading to the rest of the global economy. "Nemesis" also includes a much harder landing for China and other potentially negative geopolitical outcomes.

The elections over the past weekend in Greece, France, and Germany have opened the door to an alternate "Fragmentation" theme, which is based on a partial breakup of the eurozone. While maybe it is only rhetoric at this stage, the change in leadership and leadership's mandates increase the potential for disruption in Europe. This disruption has the potential catalyst of turning the outlook into the more adverse "Nemesis" theme. At minimum, the markets have begun increasing the discount for such an outcome.

It seems to me that the "Divergent" theme is still the best long-term outlook, but with lowered near-term expectations based on China's lowered economic growth target and at minimum headline risk in Europe. It is more likely that we are experiencing the "Stagnation" theme which reflects subpar global economic growth and high unemployment. (April's U.S. jobs data did not help.)

From a broad geographical basis, the U.S. has been the best relative performing market as seen in Figure 1 which compares the MSCI USA Index (NYSEARCA:EUSA) to the MSCI All Country World Index (NASDAQ:ACWI) index.

Figure 1

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Emerging markets are expected to rebound later this year as China re-accelerates growth. While the story got a great start through January, Emerging Markets, based on iShares MSCI Emerging Markets (NYSEARCA:EEM), began underperforming in February and turned decidedly lower in early March, coinciding with China's lowering its official targeted growth rate to 7.5%.

Figure 2

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On a global sector basis - the Energy and Material sectors have significantly underperformed the broad market. Figure 3 shows the relative underperformance of the iShares S&P Global Materials (NYSEARCA:MXI) relative to the world index ETF. (The energy sector is not shown but is not pretty either.) The materials sector showed early promise in January only to resume its down trend that began last year. At this point I don't expect the resource sectors to pick up until expectations in China improve.

Figure 3

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Time will tell if the emerging markets and resource sectors will rebound to reflect progress under the "Divergent" theme. While the U.S. has done its part, Europe is not helping, and until China shows signs of growth and a market rebound, then I believe the "Divergent" theme is on hold. The challenge as always is timing.

While I am not convinced that portfolios should be positioned for the "Nemesis" theme in the interim -- the markets have begun increasing the discount since March for a more defensive and/or low growth environment. Portfolios positioned for the more adverse "Nemesis" outlook would essentially avoid equity for short duration fixed income, U.S. dollars, and possibly gold. And if equities are necessary - focus on defensive-oriented U.S.-based names.

The next three figures highlight the relative performance of short-duration U.S. Treasuries, the U.S. dollar, and gold relative to equities. Both Treasuries and the dollar have outperformed the global equity markets since March, while gold has been flat. While there is early indications of a shift to safety, it doesn't reflect the drastic moves seen last fall.

Figure 4

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Figure 5

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Figure 6

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Conclusion

The "Divergent" theme has shown promise in the first quarter but most portfolios leveraged to this theme have likely taken a performance hit over the past one-to-two months. The "Divergent" theme is likely on hold until China rebounds and we remain in a stag-lite environment. While the "Divergent" theme can come back as a 2H'12 event, the lowered growth rate in China has increased concerns as to the timing.

I don't believe the "Nemesis" theme is the right path given likely the resolve in Europe to pull itself together - maybe with just less austerity and more opportunity for growth and maybe without Greece.

For a final thought - Accuvest's Global Opportunities ETF's (NYSEARCA:ACCU) holdings clearly show that the "Divergent" theme has legs based on the attractiveness of the emerging market countries. Accuvest's holdings are based on factor-based ranking system of the 29 investable country ETFs that makeup the MSCI All Country World Index. Five of the six holdings are in the emerging markets (as of May 09, 2012), with the remaining holding the iShares S&P 500 Index (NYSEARCA:IVV).

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